A:

At first glance, the inverse relationship between interest rates and bond prices seems somewhat illogical, but upon closer examination, makes sense. An easy way to grasp why bond prices move opposite to interest rates is to consider zero-coupon bonds, which don't pay coupons but derive their value from the difference between the purchase price and the par value paid at maturity.

For instance, if a zero-coupon bond is trading at $950 and has a par value of $1,000 (paid at maturity in one year), the bond's rate of return at the present time is approximately 5.26% ((1000-950) / 950 = 5.26%).

For a person to pay $950 for this bond, he or she must be happy with receiving a 5.26% return. But his or her satisfaction with this return depends on what else is happening in the bond market. Bond investors, like all investors, typically try to get the best return possible. If current interest rates were to rise, giving newly issued bonds a yield of 10%, then the zero-coupon bond yielding 5.26% would not only be less attractive, it wouldn't be in demand at all. Who wants a 5.26% yield when they can get 10%? To attract demand, the price of the pre-existing zero-coupon bond would have to decrease enough to match the same return yielded by prevailing interest rates. In this instance, the bond's price would drop from $950 (which gives a 5.26% yield) to $909 (which gives a 10% yield).

Now that we have an idea of how a bond's price moves in relation to interest-rate changes, it's easy to see why a bond's price would increase if prevailing interest rates were to drop. If rates dropped to 3%, our zero-coupon bond - with its yield of 5.26% - would suddenly look very attractive. More people would buy the bond, which would push the price up until the bond's yield matched the prevailing 3% rate. In this instance, the price of the bond would increase to approximately $970. Given this increase in price, you can see why bond-holders (the investors selling their bonds) benefit from a decrease in prevailing interest rates.

For a more detailed explanation of bond pricing and yield calculations, check out Advanced Bond Concepts.

RELATED FAQS
  1. What is the difference between a zero-coupon bond and a regular bond?

    The difference between a zero-coupon bond and a regular bond is that a zero-coupon bond does not pay coupons, or interest ... Read Answer >>
  2. How does an investor make money on a zero coupon bond?

    Learn about investing in zero-coupon bonds, exactly how they work as an investment vehicle, and their advantages and disadvantages ... Read Answer >>
  3. What determines the price of a bond in the open market?

    Learn more about some of the factors that influence the valuation of bonds on the open market, and why bond prices and yields ... Read Answer >>
  4. What causes a bond's price to rise?

    Learn about factors that influence the price of a bond, such as interest rate changes, credit rating, yield and overall market ... Read Answer >>
  5. How does face value differ from the price of a bond?

    Discover how bonds are traded as investment securities and understand the various terms used in bond trading, including par ... Read Answer >>
  6. How do I calculate the holding period return yield on a zero-coupon bond?

    Learn how to calculate the holding period return yield for a zero-coupon bond based on a formula with a relevant example ... Read Answer >>
Related Articles
  1. Investing

    How To Evaluate Bond Performance

    Learn about how investors should evaluate bond performance. See how the maturity of a bond can impact its exposure to interest rate risk.
  2. Investing

    Top 6 Uses For Bonds

    We break down the stodgy stereotype to see what these investments can do for you.
  3. Investing

    Investing in Bonds: 5 Mistakes to Avoid in Today's Market

    Investors need to understand the five mistakes involving interest rate risk, credit risk, complex bonds, markups and inflation to avoid in the bond market.
  4. Investing

    5 Fixed Income Plays After the Fed Rate Increase

    Learn about various ways that you can adjust a fixed income investment portfolio to mitigate the potential negative effect of rising interest rates.
  5. Investing

    Corporate Bonds: Advantages and Disadvantages

    Corporate bonds can provide compelling returns, even in low-yield environments. But they are not without risk.
  6. Investing

    Corporate Bond Basics: Learn to Invest

    Understand the basics of corporate bonds to increase your chances of positive returns.
  7. Investing

    How Rising Interest Rates Impact Bond Portfolios

    A look at the impact that changing interest rates - rising or falling - have on bonds and what investors need to consider.
  8. Investing

    Understanding Interest Rates, Inflation And Bonds

    Get to know the relationships that determine a bond's price and its payout.
  9. Investing

    Six Biggest Bond Risks

    Don't assume that you can't lose money in this market - you can. Find out how.
RELATED TERMS
  1. Bond Yield

    The amount of return an investor will realize on a bond. Several ...
  2. Bond

    A debt investment in which an investor loans money to an entity ...
  3. Discount Bond

    A bond that is issued for less than its par (or face) value, ...
  4. Dollar Price

    The percentage of par, or face value, at which a bond is quoted. ...
  5. Coupon Stripping

    The separation of a bond's periodic interest payments from its ...
  6. Bond Discount

    The amount by which the market price of a bond is lower than ...
Hot Definitions
  1. Co-pay

    A type of insurance policy where the insured pays a specified amount of out-of-pocket expenses for health-care services such ...
  2. Protectionism

    Government actions and policies that restrict or restrain international trade, often done with the intent of protecting local ...
  3. Fiduciary

    A fiduciary is a person who acts on behalf of another person, or persons to manage assets.
  4. Demonetization

    Demonetization is the act of stripping a currency unit of its status as legal tender and is necessary whenever there is a ...
  5. Investment

    An asset or item that is purchased with the hope that it will generate income or appreciate in the future. In an economic ...
  6. Redlining

    The unethical practice whereby financial institutions make it extremely difficult or impossible for residents of poor inner-city ...
Trading Center